Archive for the ‘2013 Filing Season Tips’ Category

Today is the day that Congress in its infinite wisdom has designated as the filing deadline for individual tax filers. It is also the filing deadline for partnerships and trusts. Let’s go through our list for today:

– File or extend your 1040, 1041 and 1065 forms. You can extend a 1040 with Form 4868; the trust and partnership filings are extended with Form 7004.

One of the most important things you can do today is to document your filing. If you e-file, it’s easy – you can get an electronic acceptance of your filing from the IRS computers. And you don’t have to worry about your return going astray on the way to the IRS service center.

If you are a paper-return holdout, it’s worth a trip to the post office, while there still is such a thing, to send your return or extension “certified mail, return receipt requested.” The IRS has to live by the “mailbox rule” – if it is postmarked today, it is considered filed today. Getting the date-stamped mailing receipt from the post office is your proof that you sent the thing, and getting the return receipt proves they got it. It helps if you can write the certified mail number across the top of the return or extension as extra proof. If filing on time is at all important, the extra $4.30 is cheap insurance.

– If you owe money, filing even one day late triggers a penalty of 5% of the balance due.

– If you are filing a 1065 or 1041, filing one day late triggers a penalty of $190 per K-1 on the ruturn.

– Any elections that must be made on a timely-filde return are invalid if the return is late. For example, if you are filing the day-trader election, filing a day late means the election is invalid for 2013. The stakes on that can be huge.

Iowa offers a “tuition and textbook” tax credit for certain grade school and high school expenses. While “textbooks” includes the obvious — textbooks — the definition is surprisingly broad. From the Iowa Department of Revenue (my emphasis):

Textbooks defined

“Textbooks” means books and other instructional materials used in teaching those same subjects. This includes fees, books, and materials for extracurricular activities.

So while you don’t get any tax break for the dress or dinner, the dance might get you credit, aside from whatever credit your high-schooler may give you for helping out with the costs. The Iowa credit is 25% of the first $1,000 of qualifying expenses for each dependent.

Like a polyester suit, the “at-risk rules” of the 1970s are both ugly and indestructible. They were enacted to combat tax shelters based on buying cattle or equipment with loans that were “non-recourse” — if the partnership didn’t pay the loan, the lender could only get back the cows or the tractors, and the partners were scot-free. Because the debt increased partnership basis, this enabled partners to buy deductions by buying interests in leveraged partnerships — often with loans nobody ever expected to collect — holding depreciable assets.

The at-risk rules defer losses attributable to basis that is not “at-risk.” On a K-1, the partner’s share of debt is helpfully broken into three categories:

Click to enlarge

There is space for the “recourse” and “nonrecourse” liabilities of the partnership. The “non-recourse” liabilities are normally not “at-risk,” so if you need the basis on that line to deduct your K-1 losses, you may be out of luck.

You’ll also see a space for “qualified non-recourse financing.” This is a tribute to the real-estate lobby of the 1970s, who won special treatment for non-recourse debt incurred in real estate activities. Nonrecourse debt that meets certain conditions – mostly debt from commercial lenders or government agencies – is “qualified nonrecourse financing” and is deemed to be “at-risk” under the tax law, even if it isn’t in real life.

If your losses exceed your other basis, you compute your at-risk disallowance on Form 6198.

Even if you have basis and it’s at-risk, you still might not get a deduction. If your loss is “passive,” then it may deferred until you have “passive” income or until you dispose of the passive asset.

As we discussed yesterday, you need basis in your partnership or S corporation interest to deduct losses on your K-1. There are other hurdles, but if you don’t have basis, you’re done. Your basis generally starts with your investment in your interest; it’s increased by income items reported on your K-1, and by additional investments, and it’s decreased by your share of losses, expenses and distributions.

With partnerships, there is an extra wrinkle: your basis also includes your share of debts owed by the partnership. That’s not true for S corporations. But how do you know what your share of partnership debt is?

A properly-prepared partnership return will report each partners share of debt on part K of Schedule K-1:

You can add the amounts on these lines to the amount of basis you have otherwise to determine your basis in your partnership interest. The ability to use this “inside” partnership debt as basis is a reason why partners run out of basis less often than S corporation owners do.

Why do partners get basis in partnership borrowing while S corporation don’t get basis in corporate borrowing? Because partnership tax in many ways treats the partnership as a combination of its members, rather than a separate entity. If you buy a $100,000 house with $20,000 in cash and $80,000 in borrowed money, your basis in the house if you sell it is still $100,000. Getting basis for partnership borrowings is a logical extension of this idea if you just have two people borrowing together.

You may have noticed the “Partner’s capital account analysis” on part L of the K-1, just below the debt thing:

Can you use this as a shortcut to figuring your basis? Usually not. Sometimes you can if the “Tax basis” box is checked, but even that is unreliable. It’s much safer to track your own basis year-by-year based on your original and subsequent investments, distributions and K-1 items.

So you have basis? Congratulations, but you still might not be able to deduct your losses. Your basis still has to be “at-risk,” and your losses might be non-deductible if they are “passive.”

If search statistics for the Tax Update are any indication, one of the most pressing issues for people who end up here is “why can’t I deduct my K-1 loss?”

There are three main reasons why your S corporation or partnership loss might be non-deductible:

1. You can’t deduct losses in excess of your basis.
2. Even if you have basis to deduct losses, the basis has to be “at-risk,” and
3. Even if the basis is “at-risk,” losses that are “passive” might be limited.

-It is increased by taxable income and deductible expenses, as reported in lines 1-12 of the 1120-S K-1, or lines 1-13 of the 1065 K-1.

-It is increased by tax-exempt income (like municipal bond income) and reduced by permanently non-deductible expenses (like the 50% non-deductible portion of meals and entertainment expenses); these are reported on line 16 of the 1120S K-1 and line 18 of the 1065 K-1. If you have a business that generates depletion deductions, your “excess depletion” from 1120S K-1 line 15c, or line 20 of your partnership K-1, also reduces your basis.

– It is increased by capital contributions, which appear nowhere on the 1120S K-1 and on Part I, line L of the 1065 K-1.

– It is reduced by distributions, which are on line 16 of the 1120-S K-1 and Line 19 of the 1065 K-1.

If your losses exceed your basis, your losses are limited to your basis. If you have multiple deduction items, you have to prorate them to fit your basis.

Example

Lets say you have an S corporation interest that starts 2010 with $3,000 in basis. You have a K-1 line 1 loss of 9,000, line 4 interest income of $2,000, and a charitable contribution passing through on line 12 (code A) of $1,000.

You have $5,000 in basis to deduct your $10,000 in in expenses – the opening $3,000 in basis plus the positive $2,000 interest income. You pro-rate the $10,000 expenses — you can (potentially) deduct $4,500 of line 1 loss and $500 of charitable contributions. The remaining deductions carry forward until you increase your basis via contributions, loans, or future income.

Even if you have basis, that just gets you past one hurdle. Your basis still has to be “at-risk,” and you can’t deduct a loss that’s “passive.” More on that later this week.

This is, of course, a simple example. It gets more complicated if there are distributions during the year (they count first), and if there are non-deductible expenses, like meals and entertainment. Shareholders can count direct loans they make to an S corporation in basis — but not borrowings by the S corporation from anybody else, and not guarantees of S corporation debt. You can learn more about S corporation basis at the IRS web site.

We usually think of April 15 as the deadline for settling up with the IRS for last year. But for the nation’s doughty day traders — especially the unlucky ones — it’s an important deadline for this year.

The tax law normally limits capital losses to capital gains, plus $3,000. That means many busy traders will have to hope for great advances in life extension technology to ever fully deduct their capital loss carryforwards.

There is an escape from the $3,000 treadmill for taxpayers who qualify as “traders.” The IRS explains what it means to be a “trader”:

To be engaged in business as a trader in securities, you must meet all of the following conditions:

You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.

Your activity must be substantial, and

You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

Typical holding periods for securities bought and sold.

The frequency and dollar amount of your trades during the year.

The extent to which you pursue the activity to produce income for a livelihood, and

The amount of time you devote to the activity.

If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader.

These are pretty steep tests. You pretty much need to be trying to do it for a living; another day job is a bad fact, as in this case. But if you pass these tests, you can make a “mark-to-market election” under Section 475(f) of the Internal Revenue Code to deduct trading losses as ordinary. If you make this election on time, it applies to 2013 taxes. It’s too late to make the election for 2012.

The Section 475(f) election comes at a price. If you make this election, gains are ordinary, too, and you have to mark your gains and losses on open positions to market at year-end — paying tax as if you had sold the positions on December 31. Yet if you are exclusively trading short-term, where you pay taxes on gains at ordinary rates anyway and have few open positions at any time, this may not be a great sacrifice.

This election cannot be extended, so traders need to make the election by next Monday. You make the election by attaching a statement to your 1040 or extension for 2012 with the following information:

1. That you are making an election under section 475(f) of the Internal Revenue Code;

Form 1040 is due one week from today. Procrastinators everywhere are beginning to stir into action. Many people still awaiting K-1s from partnerships are in full panic mode.

Relax.

Yes, April 15 means something. It’s unwise to just ignore it. Yet it is no cause to panic.

Here is what really needs to happen by April 15 for most taxpayers:

– You need to either file your form 1040 and pay any amount due, or

– You need to file Form 4868 and pay in your estimate of 2012 tax due. Then you have until October to get your return right the first time.

It is better to extend than amend. If you do not have all of the information you need to do your return, extend. Unless you have a huge refund on the way, the value of getting your refund a little sooner will never make up for the time and effort of amending your return. And there is no basis for the urban myth that extended returns increase your risk of being examined.

How much do I need to pay in with my extension if I owe? The general rule is that if you pay in 90% of your total tax with your extension, there is no underpayment penalty; there is only interest on the amount due at the IRS underpayment rate, currently 3%. It’s customary, though, for preparers to include in an extension an amount that will also cover projected first-quarter estimated tax payments. 1040 overpayments can be applied to the next year’s estimated taxes, and paying it with the extension gives you a little cushion if that K-1 you are waiting on has an unpleasant surprise.

If you cannot pay in 90%, you should still extend. The penalty for being underpaid on an extended return is 1/2% of the underpayment, plus 1/2% for each additional month you are underpaid. In contrast, the penalty for being underpaid if you don’t extend is 5%,plus an additional 5% for each month you remain underpaid, up to 25%.

What’s more, the IRS is running an underpayment special this year. Because Congress passed big changes to 2012 taxes after 2012 was over, many IRS forms were issued late. If you extend a return needing one of those forms, you may be able to avoid the 1/2% penalty (and the 5% penalty) on underpayments and only pay interest on owed amounts. Common forms that qualify include Form 4562 or depreciation, Form 8582, the “passive activity” form, and Form 8863 for college expenses. A complete list of qualifying forms is here, and the IRS conditions for allowing penalty relief are here.

So don’t wait on that last K-1. It’s April 8. Get what you can to your preparer, or sit down and get to work, file your extension, and exhale. It will be O.K.